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When the
European Central Bank announced its program of
government-bond purchases, it let financial markets know that it
thoroughly disliked the idea, was not fully committed to it, and
would reverse the policy as soon as it could.

Indeed,
the ECB proclaimed its belief that the stabilization of
government-bond prices brought about by such purchases would be
only temporary.

It is difficult to think of a more self-defeating way to
implement a bond-purchase program. By making it clear from the
outset that it did not trust its own policy, the ECB practically
guaranteed its failure. If it so evidently lacked confidence in
the very bonds that it was buying, why should investors feel any
differently?

The ECB continues to believe that financial stability is not part
of its core business. As its outgoing president, Jean-Claude
Trichet, put it, the ECB has “only one needle on [its]
compass, and that is inflation.”

The ECB’s refusal to be a lender of last resort forced the
creation of a surrogate institution, the European Financial
Stability Facility. But everyone in the financial markets knows
that the EFSF has insufficient firepower to undertake that task –
and that it has an unworkable governance structure to boot.

Perhaps the most astonishing thing about the ECB’s monochromatic
price-stability mission and utter disregard for financial
stability – much less for the welfare of the workers and
businesses that make up the economy – is its radical departure
from the central-banking tradition.

Modern central banking got its start in the collapse of the
British canal boom of the early 1820’s. During the financial
crisis and recession of 1825-1826, a central bank – the Bank
of England – intervened in the interest of financial
stability as the irrational exuberance of the boom turned into
the remorseful pessimism of the bust.

In his book Lombard Street, Walter Bagehot quoted
Jeremiah Harman, the governor of the Bank of England in the
1825-1826 crisis:

“We lent...by every possible means and in modes we had never
adopted before; we took in stock on security, we purchased
exchequer bills, we made advances on exchequer bills, we not only
discounted outright, but we made advances on the deposit of bills
of exchange to an immense amount, in short, by every possible
means consistent with the safety of the Bank, and we were not on
some cases over-nice. Seeing the dreadful state in which the
public were, we rendered every assistance in our power..."

The Bank of England’s charter did not give it the legal authority
to undertake such lender-of-last-resort financial-stability
operations. But the Bank undertook them anyway.

Half a generation later, Britain’s Parliament debated whether the
modifications of the Bank’s charter should give it explicit power
to conduct lender-of-last-resort operations. The answer was no:
granting explicit power would undermine confidence in price
stability, for already there was “difficulty restrain[ing]
over-issue, depreciation, and fraud.” Indeed, granting explicit
lender-of-last-resort powers to the Bank of England would mean
that the “millennium of the paper-mongers would be at hand.”

But the leaders of Parliament also believed that the absence of a
codified authority to act as lender of last resort would not keep
the Bank of England from doing so when necessity commanded. As
First Lord of the Treasury Sir Robert Peel wrote: “If it be
necessary to assume a grave responsibility, I dare say men will
be willing to assume such a responsibility.”

Our current political and economic institutions rest upon the
wager that a decentralized market provides a better
social-planning, coordination, and capital-allocation mechanism
than any other that we have yet been able to devise. But, since
the dawn of the Industrial Revolution, part of that system has
been a central financial authority that preserves trust that
contracts will be fulfilled and promises kept. Time and again,
the lender-of-last-resort role has been an indispensable part of
that function.